The Search for Lowest Cost Capital
By Eli Katz
Financings in the US relied heavily the last three years on stimulus grants and federally-guaranteed debt. Both are disappearing. The euro is in trouble with a Greek exit from the euro zone looking increasingly likely. European banks have pulled back from the project finance market. What assumptions should developers make about the future cost of capital when bidding to supply electricity? What new strategies are likely to emerge for raising debt and equity? For example, the solar industry continues to talk about REITs and rated portfolio debt.
Four veterans in the project finance market talked about the cost of capital at the Chadbourne global energy and finance conference in June. The panelists are Thomas Emmons, managing director and head of renewable energy and infrastructure finance at Rabobank, New York Branch, Duncan Scott, managing director and global head of private placements and project bonds at SG Americas Securities, Richard Randall, managing director and head of power and project finance at RBS Global Banking, and Carl Morales, a director at Sumitomo Mitsui Banking Corporation. The moderator is Eli Katz with Chadbourne in New York.
MR. KATZ: Carl Morales, there are declining subsidies and a lot of volatility in the bank markets. How should developers be evaluating this when they think of the future cost of capital for their projects?
MR. MORALES: We are headed for a tightening of terms and maybe some higher costs. Finance is moving from the bank market to the institutional debt market as a result of the European debt crisis and Basel III. Export credit agencies are also playing a larger role.
Banks Versus Capital Markets
MR. KATZ: Tom Emmons, what is going on with the banks in terms of funding and regulatory issues that is making it more difficult to get long-term debt?
MR. EMMONS: The bank market is segmented. The segment that is under the most duress is, of course, the European banks. There are regulatory pressures: Basel III is requiring banks making project finance loans to set aside more capital. The economic crisis in Europe is eroding the capital base. There is a deleveraging of balance sheets. Basically, as a category, European banks are under a lot of pressure, so you see them shrink, if not totally withdraw, from the project finance market in the US.
The good news, if you can see any good news in it, is that some other segments of the bank market are actually filling in fairly well. I would look at margins as an indication of supply and demand. Margins and fees have not increased significantly since mid-2009. The good news is that the banking market is somewhat resilient and the other categories of banks, US, Canadian and Japanese banks, seem to be filling the void.
MR. KATZ: Most developers are looking for longer-term debt. As you think about the different banks, who is the best target for that and why?
MR. EMMONS: Banks are intermediaries. They basically take deposits and lend them out again. Insurance companies and pension funds are really investors: they have a pool of capital that they need to invest. So per textbook corporate finance, long-term debt is better matched to institutions. Banks typically would do the shorter term or the part of project finance work where construction is involved meaning that there will be more complicated draws and repayments. Institutions like to put the money out all at once. They will do construction debt and take construction risk, but the sweet spot for institutions is long-term, low-risk chunky investments. The reason why institutions were not the main lenders to the sector in the past is that European banks over the last decade considered their cost of capital lower than it really was, so they began competing with institutions and lending up 18 years and that has basically come to a halt.
MR. KATZ: Do you see that restarting anytime soon?
MR. EMMONS: There are some non-European banks still making long-term loans. But no, I do not see that coming back. I see this as a fundamental shift mostly due to regulation and higher capital costs. I think the institutions are probably competitive again, and banks are coming down significantly in maturity.
MR. KATZ: Duncan Scott and Rich Randall work more in the capital markets. Since the place to get long-term debt is now the capital markets, will you talk about what those markets look like, how many active players there are and whether they are healthy?
MR. SCOTT: Those markets are obviously huge. Over the last five to 10 years, the capital markets have been a niche part of project finance lending. Renewable energy companies are less familiar with the capital markets. The role of these markets is growing. A number of the institutional lenders participated in loan guarantee transactions last year to the renewable energy sector. This has contributed to a widening of knowledge among institutions about renewables projects.
There has always been a very active handful of life insurance companies who have understood these projects and have been active in them. Of obvious interest to this audience is how we widen institutional participation in the sector. That is the ongoing challenge, and it has accelerated in the last 12 months with the withdrawal of many long-term lending banks. Many developers have no choice but to look to institutions and to begin to adapt their requirements, their returns and their structure expectations to an audience that is similar but different.
MR. KATZ: Rich Randall, banks are notoriously inflexible. Do you have the same thing in the capital markets? Do you get more flexibility in terms of who your offtaker is? Do you get more flexibility in terms of tenor? What sorts of things do you get in the capital markets that make it a more advantageous place for developers to borrow?
MR. RANDALL: Our developer clients would probably say the capital markets are less flexible than the banks. I think the only flexibility you get is on tenor. Essentially the two markets are almost identical in structure and in creditor arrangements. There are still tranche deals. They are still very similar.
The disconnect comes as the bank markets fade and focus more on the short-term aspects of projects like getting through construction and we start to fund these projects as 25- to 30-year assets in the institutional debt market. There is a bit of a breakdown in the market right now as developers want to retain flexibility to refinance long-term debt while insurance companies and pension funds want a truly long-term instrument. We have seen a lot of flow in the last two years compared to the recent past. I would have expected to see more.
Banks tend to be gravitating to a 5- to 7-year structure. Insurance companies want 20-year debt. There is a void in the market for a 10-year type of instrument, and it will be interesting to see whether institutional money fills that gap. Pricing has crept up, and we are now looking at pricing in the institutional debt market that is more akin to bank loan-type pricing. The low rates that the European banks were offering in the last five years are starting to move upward. There is an opening for institutional money to fill that gap.
MR. SCOTT: Renewable energy developers are looking for long-term money to match their assets and talking to both institutions and banks. The fundamental difference between the two markets is the institutional debt market is interested in lending long term at fixed rates. It is potentially a game-changing perspective for developers. The insurance companies and pension funds do not have the same long-term experience with performance of these assets that the banks have. They have not been tracking the technology changes. They end up looking through the prism of the rating agencies. The rating agencies color the views of a lot of institutions.
The rating agencies have been skeptical about wind projects and wind resources. They remember one high-profile project that they rated several years ago that did not perform as expected. They are unaware that 95% of the transactions turn out well. It is a chicken-and-egg problem to kickstart the market.
Term B Loans
MR. KATZ: Rich Randall, what is a term B loan and where does it fit in the capital structure?
MR. RANDALL: It is essentially the same as bank debt. It has a floating rate that is LIBOR based and a tenor of seven years. It can be prepaid easily. There may be some call restrictions in the first couple of years, but it is a very flexible financing. It is distributed primarily to holders of CLOs. Some insurance companies and hedge funds buy term B loans as well. They are sub-investment grade, around BB. The term B loan market was very active before the economy crashed in the fall 2008. It has come back quite a bit since then. It is very similar to the high-yield bond market: a floating-rate instrument but senior secured debt.
Term B loans are a good barometer for the true cost of capital. The reason we see bank pricing gravitating more towards the terms in the institutional debt market is because banks, for lack of a better word, were lying to themselves about their true cost of capital, and reality has caught up. You see bank pricing gravitating to where the B loan market is.
MR. KATZ: What is the pricing difference between a B loan and a senior secured term loan from a bank?
MR. RANDALL: A BB credit probably has to pay 350 to 450 basis points over LIBOR in the B loan market. A project finance bank loan, which is usually a BB+ finance credit, is gravitating around 300 basis points over LIBOR right now. There are also upfront fees.
MR. EMMONS: We have seen B loans often applied to holding companies. If a developer has a long-term power contract, it can generally get full leverage at the project level, so there is no room for another mezzanine debt tranche. However, developers borrowing against portfolios of projects borrow at the level of a holding company one tier up from the project companies and secure the B loan by pledging the equity interests in the project companies.
MR. RANDALL: Three years ago, we had 40 or 50 banks to whom we syndicated debt. Last year, 25 banks did four or more deals. That was our definition of active. This year the list is about 15. We are seeing the bank market shrink. Usually, when you see that amount of liquidity leaving the market, you would see pricing increase dramatically. I think what offset that is that we have some Japanese and Canadian players and a couple of regional US banks coming in.
Demand is down at the same time. It is hard for developers to persuade utilities to sign long-term power contracts. We are not seeing the volume in projects that we usually do. North American project finance is around a $30-to-$40 billion-a-year market. This year, it will probably be around $20 billion.
I think demand will recover for project finance debt in a couple years. That demand will have to be filled from some other pool of capital that needs to form. Times like these see new pools of capital form, so it will be interesting to see whether the additional capital will come from the B loan market. There has been resistance to single asset financing from that market.
MR. KATZ: People would like to raise more money from infrastructure funds to fill in the equity portion of the capital structure. Yet a lot of private equity funds do not seem to match up well with renewable energy assets. Do you agree with that perception, and why is there a mismatch?
MR. MORALES: The private equity funds have high hurdle rates to meet, and the perception is that they usually cannot make the numbers work.
MR. SCOTT: Most of the infrastructure funds with whom I have dealt are most interested in assets with predictable cash flows. This is not what one finds in renewables projects. The infrastructure funds are used to looking at long-dated infrastructure assets, social infrastructure and transportation infrastructure. It takes time to get comfortable with resource risk.
MR. RANDALL: These private pools of capital have had to adapt to the current phase of the market. Before 2008 when renewables were booming, there were opportunities for private equity shops to make money by investing in developers and benefiting from their growth. They could benefit from
rollups that would, in many cases, be sold to European investors. Basically the cycle is now reversed. Now you have a number of European investors selling off their portfolios. Returns on capital of 30% or more are just not available in at least the volume that they used to be. We are seeing some private equity shops in a sense morphing into infrastructure funds. I think a lot of them may not admit that they are looking for high single-digit or low double-digit returns, but that is what is available these days with a maturing pool of assets. The big returns are just not available like they used to be.
MR. KATZ: Carl Morales, Sumitomo does lease financing, which is a form of raising equity. Could you talk about the pricing of that product and whether you can combine it with other pieces of a traditional capital structure like debt?
MR. MORALES: The bank has tax capacity, and we are looking to deploy it. The returns are equivalent to returns in partnership flip transactions. Our focus is on single-investor leases where the lessor pays full value for the project using equity. We are not crazy about leveraged leases in project finance transactions because we are behind a lender in the capital structure.
MR. KATZ: Switching gears, there is a perception that a lot of European investors or maybe even Asian investors have a preference for US-dollar-denominated assets. Do you see that happening? How does that translate into pricing or tenor for any piece of the capital structure for power assets?
MR. RANDALL: There was talk a couple years ago that Asian investors were looking to invest in the US. We spent a lot of time in Japan and other parts of Asia looking for investors, but it became a very crowded field with many others also searching for such investors. It is hard to find Asians willing to lend. There is more interest in investing equity. Asian investors want contracted projects with long-term power contracts with creditworthy utilities. Returns for such projects have fallen to the high single digits. Infrastructure funds that had been funding highways and bridges have started looking at energy as well. This has put further downward pressure on returns.
The price of debt has increased to 5% to 6%. At the same time, equity returns have compressed to 8% to 9%, so you have a low spread between debt and equity, but you still have a huge difference in risk between the two positions. If you start to talk about merchant energy or anything that adds risk, a lot of that equity disappears pretty quickly. It is not just Asian investors, it is also infrastructure funds and sovereign wealth funds who disappear, so we see a lot of people cancelling the debt because they cannot find the equity, even for fully contracted projects. Consider in addition that there are not a lot of projects with long-term power contracts coming to market.
MR. KATZ: Is it possible to get any form of financing on a merchant project? If not, what happens in a market where there are not a lot of contracted projects?
MR. RANDALL: As the renewable energy market starts to tail off, we are starting to see new activity on the thermal side. We see some gas-fired projects with merchant components to them. We will not see a return to the period before Enron went bankrupt where banks were financing purely merchant projects. However, a quasi-merchant project may be financeable in an established market with a good track record. The transaction will work only if there is low leverage and maybe some level of hedging. With $2 gas, it is inevitable we are going to build more gas-fired power plants. Only a subset of lenders will consider projects with merchant risk.
MR. KATZ: Will the banks on this panel lend to a thermal project where not everything is fully contracted?
MR. MORALES: To be perfectly honest with you, we will not. Although we have done it before, we do not have an appetite for merchant risk at this time. From a risk management perspective, our institution is not comfortable with the non-contracted risk. We are not willing to make a credit decision on a “story.” At least for now, we are looking only at fully contracted projects and no merchants.
MR. EMMONS: We only do renewable energy projects and, within the renewables category, we avoid market price risk which is the same thing as saying we will only lend against contracted revenues.
MR. KATZ: There are times in the cycle when banks are willing to finance merchant projects. What happens that changes their minds? Is it that you run out of contracted projects to finance or your funding sources loosen up? What would have to happen to change your minds?
MR. EMMONS: The last time banks lent against merchant projects was more than 10 years ago, and there was a lot of blood on the floor as a result. The reason for the last foray into merchant was there were a lot of fully-staffed banking groups with nothing else to do coupled with a lot of irrational exuberance. A lot of money was lost. The banks have not forgotten that. There are very few banks who will lend merchant.
MR. KATZ: Dan Reicher wrote an op-ed piece in the New York Times recently pointing out that renewable energy is at disadvantage because it does not have access to retail investors like the oil and gas industry has with master limited partnerships and the real estate industry has with real estate investment trusts. Are a lot of people talking about opening renewable energy to retail investors? What would that do to pricing if those markets could open up?
MR. RANDALL: There has been talk for several years now about using MLPs or REITs. However, use of MLPs requires a statutory change by Congress and people see such a change as an uphill battle, especially in an election year. For quite a while, people in the industry have said if you can get those tax credits in the hands of retail investors, then the market would become much more efficient. I believe that, too. The efficiency will drive down the cost of tax equity. MLPs would simplify a lot of the capital structure.
MR. KATZ: Putting aside the tax piece, if you could raise money against the cash flows using MLP or REIT structures, do you think that would be a game changer for the industry? Would it bring down the cost of capital significantly?
MR. RANDALL: If you are planning to use such a structure to finance a single asset, I do not think it will have a big impact. You sell the first loss layer to a tax equity investor. The MLP equity is behind other pieces of the capital structure. This will not affect the cost. Where I think you get some effective pricing is when you start to do stuff on a corporate basis. You put a bunch of assets together in an MLP and go leverage them on a corporate basis. That is where you get some real efficiencies by moving out of single asset nonrecourse structures.
MR. KATZ: Let me ask a general tax equity question because tax equity remains an important piece of the capital structure. Do you think pricing will move up or down over the next year or two?
MR. RANDALL: I think we are going to see some new entrants, including ourselves. Some regional banks are looking at investing tax equity. Developers have been trying to tap the corporates and I think with the right structure, you might see some more of them entering the market. Yield is the main driver for people.
MR. KATZ: Where do you think you will be spending your time over the next 18 months? What new trends do you see in the market?
MR. RANDALL: In terms of lending, I think we will be spending a lot of time on M&A. I expect M&A will be where we spend most of our time on the advisory side, too. With so much equity chasing projects, we are starting to see more M&A activity. A lot of European companies are going home and liquidating assets. If you own assets, it is not a bad time to sell. I also expect to see more new construction of thermal power plants. There are going to be some interesting structures around quasi-merchant risk.
MR. SCOTT: I might echo the gas build situation in the US.
I expect to see continued activity in the wind sector, especially in the south, but at a lower level than in the past. Sponsors, certainly some of the European sponsors, who have amassed a critical mass of assets in the US, will be beginning to look to refinance those on a portfolio basis or in quasi-corporate transactions. There will be much more activity in mid-stream gas assets. There has been a fundamental change in the direction in which liquids and gas move around the US. There is growing activity in selected countries in Latin America.
MR. EMMONS: There is no one category that is going to be a big growth area, but if production tax credits are not renewed by Congress, then on-shore wind will wane. If the tax credits are renewed, then I think on-shore wind will remain a major area of focus. Mid-size, commercial and industrial solar will be a growth area because that market will continue to benefit from tax subsidies and the market penetration of PV is still low. Offshore wind will never be a huge sector, but hopefully there will be a few large deals over the next few years. We hope to be active there, but it will not be a huge segment of the market.
MR. MORALES: We will continue to push our core debt business on the project finance side and try to grow the tax equity business. We have a strong interest in doing export credit agency transactions. We have a very strong Latin American presence, so that will be an area where we also expect to see growth.